Naive Investor Chapter 4: Expectations and Emotional Framework

There are decisions to be made. So its important to reign in and get a handle on your expectations. Why do you want to invest your money?

Most likely you will want more money, but why? How much? What for? The vast majority of people with pocket change in the world simply want an income that will preserve their current lifestyle when they stop working/having an active income. But other people want to be rich, to win big. Yet other people it is about keeping up with the jones' and investing becomes a largely negative experience.

Hence Benjamin Graham warns against not having an intellectual framework to overcome the emotions that break down discipline. He has the powerful metaphore of 'Mr. Market'.

I don't want to go too far into the various investment classes, but lets look at shares to illustrate 'Mr.Market.' A guy who is taken by chronic pessimism followed by chronic optimism on a daily basis. He is an annoying friend that comes by every day offering to sell everything he owns or buy it all at fluctuating prices. You are under no obligation to buy or sell or even listen to Mr. Market but you can feel free to take advantage of his wild moodswings. Because he just determines prices based on his erratic moods, not the underlying businesses he has (or hasn't) got shares in.

Mr. Market tells you nothing more than what mood he is in, thus it creates good and bad prices to buy at. But we are getting ahead of ourselves.

The point is that the market 'will fluctuate' as per JP Morgan's prophetic words. But whether the various investment markets go up and down is largely irrelevent until you put a context on it.

We have established as per chapter 3, that the minimum expectation we hold of our investment performance is that it beats inflation. Or it's net performance (after tax, fees etc.) is better than inflation. That way at least you will be getting richer with your savings in terms of purchasing prices. This is a reasonable expectation and is generally not too hard to do.

Many though go beyond inflation and look to your financial goals, your goals will have some quantity you can affix to it, some annual return and it should have a firm basis in reality. Something to the tune of an average 6% etc.is much more reasonable (more than twice as reasonable) as a sustained 14% per annum.

It is highly possible that the market itself will generate this return, thus there is no reason to try difficult operations like picking winners from the share market. An index fund will track the market's performance (making the news more meaningful because they will always report the index performance).

Historically 'beating the market' is notoriously hard, particularly over the long term. The only success stories that are sustained are Ben Graham's value based investor progeny. But for most financial goals it is largely irrelevant, an index fund will share the fate of the market as a whole and will generally generate an adequate return provided the majority of businesses stay in business because they are fundamentally competent.

Even performing poorer than the market average may result in wealth.

Your expectations as such need to be rooted in a concrete goal, and all performance should be measured in the context of this goal. Who cares if you could have performed even better, if you have achieved everything you set out to anyway. Breaking a world record is nice, but it should be sufficient to just win.

Enter the Jones' whom we are all constantly trying to keep up with, they introduce the best and fastest way to possibly lose. It's the breakdown of any discipline into chasing the next hottest investment strategy or class. It means breaking from your strategy and suffering the consequences. To change up your strategy in the pursuit of a few more percentages, will incur transaction fees, tax and generally higher risk. Because profit = risk.

Good financial performance is always in the past, the future is always uncertain. What worked for the Jones' is irrelevant, because the price they bought in to that investment doesn't exist anymore. If it did there wouldn't be anything for the Jones' to brag about. That is a mathematical certainty.

Emotion also provides other losing behaviours, for example an amateur investor will purchase several types of investment and after a period of time some will have performed well, some better than others and others will lose money. What does an emotional investor do? Sell the winners to realize their success and reward themselves and hang onto the duds in the hope they turn good and correct their losses.

Lastly we have to look at cognitive dissonance as it applies to the unrealistic expectation of 'getting rich'. In many ways investment opens a theoretical path to being rich no matter what occupation or vocation you choose. Which it does if you make infallible timing decisions etc.

But let me wax ethical and say: if you haven't taken the risks, and put the time and effort into being rich you have no right to be. It is well established that there is no justice in the world, but really for your sake one of the best investments you can make is to not be an arsehole.

To say profit = risk is to state fact, the wealthiest people in the world have the most concentrated investment portfolios. They backed one horse and won. Bill Gates with Microsoft, Ted Turner with CNN etc. if those businesses had failed we would never heard of them and they would be on the street asking for change (a decent living it would seem).

They exposed themselves to this downside, in order to gain exposure to the upside. If you chose a nice stable profession in Engineering, Law or Medicine with steady income and regular hours you have no business shooting for the moon. You were never aiming there.

It is enough to simply preserve your purchasing power (through savings) and protect these savings against inflation (through a modest and realistic investment strategy).

If you want the big prize you have to accept the possibility of the big losses. The emotional default though is 'win-win' as in people want the profits, but no exposure to losses. Its why people speculating on the sharemarket feel outrage that company CEOs aren't thrown in jail and often recieve bonuses. They feel angry at a government not bailing out their investments.

If you don't have a healthy fear of the downside going in you are far more likely to experience it.

Thus the most important thing to develope is an intellectual framework for investing. Discipline.

Its a two step process:

1. What do you need? (want)
2. Are you willing to pay the price for it?

If you aren't willing to have your portfolio drop by 30-50% you have no business betting on a 'hot stock' to gain the 17% upside.

More later.